A short duration debt fund, also called a short-term debt fund, invests in money market instruments and debt like government securities, commercial papers, treasury bills, and deposit certificates. On SEBI mandates, these funds are not only for the short term but open-ended also. Moreover, a short duration debt fund has the Macaulay Duration, which, simply put, is the weighted average of the number of years in which the present cash flow values equals the cost of investment in a fixed-income instrument for a period of one to three years.
What are short duration debt funds?
Short duration debt funds are a category of debt mutual funds that invest in fixed-income securities such as corporate bonds, government securities, and money market instruments with a Macaulay duration of 1 to 3 years. These funds are designed to offer a balance between returns and risk for investors with a short to medium-term investment horizon.
They are less volatile than long-duration funds but offer better returns than liquid or ultra-short-term funds. Because of their relatively low sensitivity to interest rate changes, they are considered suitable during uncertain or rising interest rate scenarios. Investors looking for alternatives to traditional fixed deposits, while keeping their risk moderate, often consider short duration debt funds.
These funds are ideal for conservative investors who seek predictable returns without locking in their money for a long period. Their diversified portfolios also help manage credit and interest rate risks effectively while preserving capital.
For how long does a short duration debt fund operate?
The fund’s duration is dependent on its underlying securities’ maturity. Duration is also a gauge of the impact on the fund’s value and is based on interest rate fluctuations in the market. If the duration is high, so will the volatility arising from rapidly fluctuating interest rates in the market. Hence, the interest rate risk will also be higher.
Objectives of a short duration debt fund
The fundamental target of a short duration debt fund is investing in secured instruments that are hardly influenced by fluctuating interest rates in the market. Hence, such funds are less affected by changes in interest rates. Moreover, such funds are relatively more stable than long-term debt funds, give higher returns than the Ultra-Short Duration Funds and are quite liquid also.
How does short duration funds work?
Short duration funds primarily invest in debt instruments such as corporate bonds, treasury bills, government securities, and commercial papers with a Macaulay duration of 1 to 3 years. The duration of a debt fund refers to the weighted average time it takes to receive all interest payments and principal repayment. By focusing on short-term securities, these funds aim to reduce the impact of interest rate fluctuations while offering relatively stable returns.
The fund manager actively selects a mix of securities based on credit quality, yield potential, and prevailing interest rate trends. Since the securities mature within a few years, the portfolio is regularly refreshed with new instruments, which helps manage reinvestment and interest rate risk more effectively.
In a rising interest rate environment, short duration funds are less affected than long-duration funds because they hold shorter maturity assets. This makes them an attractive option for investors looking to preserve capital while earning better returns than savings accounts or fixed deposits.
These funds are well-suited for investors with a moderate risk appetite and a short to medium investment horizon, typically ranging from 1 to 3 years. Their working mechanism makes them a popular choice for strategic debt allocation in a diversified portfolio.
Benefits of Short Duration Debt Funds
Preferred by Newcomers
Newcomers to the debt market find short-term debt funds ideal since they are usually risk-averse but look forward to decent returns on their investments and also easy liquidity.
Stable Returns
A short duration debt fund gives out more stable returns over short durations owing to interest rate cycles easing and tightening, compared to fixed deposits, Short-term Mutual Funds, or Ultra-Short Duration Funds.
Lower risks
In any adverse market condition, the risk factor is lower since deviations downward are lower, which helps preserve the capital in the long run. However, it may be said that no short duration debt fund is absolutely risk-free.
Higher liquidity
Since short duration debt funds have no lock-in period, they can be sold anytime, particularly during financial emergencies, subject to exit load and tax implications, if any.
The other notable benefits are as follows:
- Less affected by inflation-related risks since SEBI has mandated following the Macaulay Duration principle.
- A good investment for earning capital in times of lower interest rates since the value of the fund increases on the spiralling prices of its underlying investments.
- Higher Yield to Maturity (YTM) since a short duration debt fund also earns from capital gains besides interest/dividend income.
- Lower risk of default as against credit risk funds since these are mostly investment-grade securities. Any equity investment lower than 65% is not termed equity but a debt fund.
- There is no lock-in period since these are unregulated broadly and depend on the investment pattern of the fund manager along with the current portfolio allocation of the investor.
Taxation of Short Duration Debt Funds
Debt funds, including short-duration funds, primarily consist of debt securities and are categorized as 'other than equity-oriented funds' for tax purposes. The tax implications for these funds depend on the duration of the investment.
Short-Term Capital Gains (STCG)
- If the investment is held for less than 36 months, any gains are considered STCG.
- These gains are added to the investor's taxable income and are taxed at the applicable regular tax rates.
Long-Term Capital Gains (LTCG)
- If the units are held for 36 months or more, the gains are classified as LTCG.
- LTCG are taxed at a rate of 20% (plus applicable surcharge and Cess).
- Investors can benefit from indexation, which adjusts the invested amount for inflation based on the Cost Inflation Index (CII) notified by the government. This adjustment effectively lowers the tax rate on LTCG for these funds.
Who should invest in short duration funds?
Short duration funds are best suited for investors who have a short to medium-term investment horizon—typically between 1 to 3 years—and want to earn better returns than traditional savings instruments without taking on excessive risk.
They are ideal for:
Moderate risk-takers: Investors who want a balanced approach between safety and returns without the high volatility of long-duration debt or equity funds.
Goal-based savers: Individuals saving for near-term goals like a vacation, child’s school fees, or emergency funds.
Retirees and conservative investors: Those who prefer stable income from interest and want limited exposure to market risks.
Investors in rising interest rate environments: Since short duration funds are less sensitive to interest rate movements, they perform relatively well when rates increase.
Fixed deposit alternatives: Those seeking higher returns than FDs, but with manageable risk and sufficient liquidity.
Conclusion
Short Duration Debt Funds offer a compelling investment option for those seeking to balance returns with risk management. By investing in debt and money market instruments with a Macaulay duration between one to three years, these funds provide a moderate level of interest rate risk while potentially offering better accrual income compared to other short-term instruments. The careful management of credit risk and the relatively straightforward investment process make these funds accessible and appealing to a wide range of investors.
Moreover, understanding the tax implications is crucial for making informed investment decisions. Short Duration Debt Funds are taxed based on the holding period, with Short-Term Capital Gains (STCG) being taxed at regular income tax rates for investments held less than 36 months, and Long-Term Capital Gains (LTCG) benefiting from a lower effective tax rate due to the indexation benefit for investments held 36 months or more.
In summary, Short Duration Debt Funds can be a suitable choice for investors looking for a blend of stability, manageable risk, and potential for moderate returns, making them an attractive component of a diversified investment portfolio.
